Why financial sector reform
is a crucial element of a long-term growth strategy

China’s emergence as an economic power and its sheer size have
put it firmly at the center of the global economic stage. Its remarkable
pace of growth has attracted a lot of attention, with some observers speculating
that it could become the world’s second-largest economy if this
rate of growth were to be sustained for the next two or three decades.
Furthermore, in light of China’s trade expansion and rapidly rising
stock of international reserves, discussions of global current account
imbalances invariably put the spotlight on Beijing. At the same time,
the possibilities of overheating and excessive investment in China are
raising concerns, because a downturn in its growth could reverberate not
just domestically but also in the Asian region and beyond.

Indeed, China’s recent move to allow for more flexibility of the
renminbi’s exchange rate (by linking it to a basket of currencies
rather than a fixed peg to the U.S. dollar) is seen as a response to both
domestic and international pressures. Some observers have dismissed this
initial step, which included a small revaluation of the renminbi, as being
too modest to make much of a difference to domestic or international imbalances.
What is more important, however, is the symbolic as well as economic significance
of this step in terms of setting in motion the shift toward greater exchange
rate flexibility and the authorities’ stated goal of eventual capital
account convertibility.

But the exchange rate regime is just one piece of the broader reform
agenda. This article provides an assessment of what China needs to do
to ensure the durability of its economic expansion by addressing the looming
issues of financial sector reform and the need to bolster balanced domestic-led
growth.

Trade patterns and the reserve buildup

To gain a better understanding of the implications of China’s currency
policy and growth strategy, it is helpful to examine the dynamics of China’s
international trade patterns and rapid reserve accumulation.

Let us begin with a regional perspective. China is becoming increasingly
important in the Asian region in terms of both trade and financial flows.
It now accounts for about 40 percent of all foreign direct investment
(FDI) inflows into emerging market economies in Asia (including FDI flowing
between Asian economies). On the flip side, Japan and the emerging market
economies of Asia together now account for more than two-thirds of China’s
FDI inflows. This share remains well over half, even if one excludes a
significant share of flows from Hong Kong SAR on the premise that these
may represent round-tripping of capital originating from China to take
advantage of preferential tax treatment afforded to FDI.

These patterns of intraregional capital flows are tied in to developments
on the trade front, where China has become a major processing hub for
goods manufactured in other Asian economies and destined for industrial
country markets. Indeed, over the period 2000–04, the increase in
China’s combined bilateral surpluses with the United States and
the European Union was offset to a significant extent by the increase
in its trade deficit with other Asian economies (see table).

Swings and roundabouts
China has a big trade surplus with the United States and the European
Union but a large deficit with its Asian neighbors.

Notes: By taking mainland China and Hong Kong SAR together,
the second panel includes imports and exports to the mainland that
are intermediated through Hong Kong SAR (during 2002–04, about
one-fifth of the mainland’s merchandise trade was intermediated
through Hong Kong SAR). "Rest of Asia" covers Cambodia,
Indonesia, Korea, Laos, Malaysia, Myanmar, Philippines, Singapore,
Thailand, Taiwan Province of China, and Vietnam.

But this is hardly the full picture. China’s current account surplus
rose to about $70 billion in 2004, with the overall trade surplus accounting
for the major portion of this increase. During 2001–04, Chinese
exports grew at a remarkable rate of about 30 percent on average each
year (imports grew at a similar rate, but the level of imports has remained
lower than that of exports). While this rapid export growth since 2001
can be attributed partly to China’s low labor costs and accession
to the World Trade Organization, there has been a contentious debate about
the significance of the role of its currency regime in generating this
trade expansion.

From 1995 to July 2005, China’s currency—the renminbi—was
effectively maintained at a fixed parity relative to the U.S. dollar and
there were indications that, with the decline in the value of the dollar
relative to other major currencies over the last 2–3 years, the
renminbi had become undervalued. Critics of China’s exchange rate
policy have frequently pointed to the country’s rapid reserve accumulation
as clear evidence of such currency undervaluation. Its gross international
reserves have been on a sharp upward trajectory since 2001, with about
three-fourths of the total buildup over the last decade taking place in
just the last three years (see Chart 1). As a result, China now has the
second largest stock of international reserves in the world (after Japan).

How have different components of the balance of payments contributed
to this surge? As Chart 2 shows, current account surpluses and net inflows
of FDI have been consistently quite large over the last decade. What is
particularly interesting is that, until 2000, these factors were offset
by the non-FDI financial account balance plus errors and omissions, the
latter being the residual balancing category in the balance of payments
that typically captures unrecorded flows in both the current and capital
accounts. Since 2001, the sum of errors and omissions and the non-FDI
capital account balance has swung around markedly, turning sharply positive
in 2003–04. Indeed, this category has been the dominant contributor
to the surge in the pace of reserve accumulation since 2001. A likely
reason for the turnaround is that it represents large inflows of speculative
capital in anticipation of a possible appreciation of the renminbi. Such
flows may not enter through official channels since they would otherwise
run afoul of capital controls.

This analysis of the forces influencing the recent sharp increase in
the pace of reserve accumulation has some important implications. For
one, it makes it less obvious that the rapid accumulation of reserves
by itself constitutes clear evidence of a substantial undervaluation of
the renminbi. Speculative inflows tend to feed on themselves and may sometimes
bear little relation to macroeconomic fundamentals. But there are no doubt
more fundamental forces putting continued upward pressure on the renminbi,
including what appears to be a higher rate of labor productivity growth
in China compared to its major trading partners.

Flexibility reduces risks

As has been evident in recent years, resisting such fundamental forces
for currency appreciation by maintaining a fixed exchange rate regime
has spurred large capital inflows. Such inflows typically have deleterious
consequences by flooding the monetary system with liquidity, which could
end up in a misallocation of resources and fuel domestic inflation.

China has been able to counteract some of these domestic pressures by
undertaking sterilized intervention—that is, withdrawing from the
financial system the liquidity increase that would otherwise result from
capital inflows and the associated accumulation of reserves. The explicit
costs of such sterilization have been held down simply by requiring the
state banks to purchase government (or central bank) bonds at low interest
rates that are close to, or below, the rate of return earned on reserve
holdings. This approach has been facilitated by the relatively closed
capital account and the fact that the banking system is state owned.

Of course, even China cannot escape the basic laws of economics. In truth,
the broader costs of sterilization may just not be obvious. For instance,
a major part of the costs has been implicitly borne by Chinese households
who, for want of other investment opportunities, have left their deposits
in the state-owned banking system and earned very low real returns on
their savings.

A greater concern engendered by the fixed exchange rate regime had been
that, over time, the capital controls would prove increasingly ineffectual
as the incentives to evade them became stronger. Maintaining a fixed exchange
rate system in the face of the inevitable erosion of capital controls
could have posed risks to the financial system, which remains weak in
many respects.

Thus, in many ways, moving toward greater exchange rate flexibility will
mitigate some of these costs and help foster economic stability in China.
But that is hardly the end of the story.

Concentration of investment

A different perspective on the balance of payments is that the current
account, in effect, represents the balance between domestic saving and
domestic investment. Chinese saving rates are very high, with gross national
saving amounting to almost half of GDP—this includes saving by households,
the corporate sector, and the government. Perhaps the real question is
why the current account surplus is only 5 percent of GDP since even this
implies a ratio of investment to GDP that is an astonishing 40–45
percent of GDP, with a substantial fraction of this investment being undertaken
by enterprises. Cheap bank credit has played an important role in financing
the recent investment boom.

Such high investment rates are, in principle, a boon for a developing
economy, since most such economies tend to be labor-rich but capital-poor.
Indeed, one could point to China’s relatively well-developed infrastructure—much
better than in many other economies at a similar stage of development—as
a positive effect of such investment. But the disturbing fact is that,
in recent years, investment growth has been mostly concentrated in a few
sectors such as aluminum, autos, cement, real estate, and steel.

While demand growth has been strong, there is a fear that annual rates
of investment growth exceeding 50 percent in some of these sectors—fueled
by cheap credit and overoptimistic expectations about future growth in
demand—are likely to result in a buildup of excess capacity. Indeed,
in some sectors such as autos and steel, there is already some evidence
that rising competition and excess capacity are beginning to drive down
prices. This could result in an accumulation of new nonperforming loans
in the banking system, setting back a good deal of the progress that has
been achieved in recent years.

In short, one basic problem in China is that the high degree of thrift
that fuels such rapid investment growth has a low payoff because of the
fragile threads holding the economic picture together. Providing cheap
capital to enterprises, especially state-owned firms, requires low interest
rates. Sustaining bank profits then requires correspondingly lower rates
of return on deposits. Thus, maintaining economically unviable state enterprises
and supporting them through the banking system results in large implicit
costs.

But why does all of this matter if growth remains as robust as it has
in recent years? Could not China simply grow out of a lot of its problems?
Growth is undoubtedly a wonderful tonic. But there is a potential dark
side associated with the fact that a significant portion of this growth
in recent years has come from investment, with rising fixed investment
becoming the main driver of output growth since 2001 (see Chart 3). A
good chunk of this investment is likely to prove unproductive from a long-term
perspective. Even building bridges to nowhere can raise output in the
short term but is hardly a good use of resources. For it is ultimately
consumption rather than investment or even output that is a true measure
of economic welfare.

Squaring the circle

So how does one square the circle? The answer—one that the Chinese
authorities themselves recognize as being crucial to China’s sustainable
long-term growth—is financial sector reform. Whether or not the
financial system becomes more efficient at intermediating China’s
large pool of saving and directing it to the most productive investments
will have major repercussions on long-term growth. Reform of the state-owned
banking sector is an essential component of this agenda since banks continue
to dominate the financial landscape, with the stock and bond markets still
relatively underdeveloped. But development of the broader financial sector
cannot be ignored, because this will be essential to provide alternative
vehicles for saving and alternative sources of financing for firms and
households. This would have the added benefit of promoting banking reforms
by exposing state banks to domestic competition.

Progress has already been made in improving the oversight of the banking
system. The formation of the China Banking Regulatory Commission in early
2003 and its mandate to improve the supervision and regulation of the
banking system have provided a kick-start to banking reforms. Capital
injections into three of the major banks have improved their balance sheets
and are bringing their capital adequacy ratios in line with international
norms. And foreign strategic investors, who are being invited in and have
begun taking stakes in the large banks, are expected to bring in technical
expertise and inculcate improved corporate governance practices.

But it is difficult to turn around behemoths on a dime. And notwithstanding
measures taken to streamline their operations, the large Chinese banks
are still massive by any standards—with hundreds of thousands of
employees and tens of thousands of branches in far-flung areas. This makes
the reform process a logistical challenge. Furthermore, rooting out the
legacy of government-directed lending, and training banks to make lending
decisions based purely on commercial considerations, with adequate regard
to viability and riskiness of projects, remains a major reform challenge.
The recent liberalization of lending rates, which will allow banks to
price risk appropriately, should improve the commercial orientation of
banks’ lending practices.

If these reforms were to lead to an increase in interest rates, might
it not trigger a reduction in investment and increase saving, thereby
adding to China’s current account surplus? This is far from obvious.
Consider saving first. Providing households with opportunities to use
financial markets to smooth consumption could in fact reduce the level
of saving for precautionary purposes. It would also allow individuals
to borrow against their future income and could thereby spur consumption
growth. Saving by enterprises could also decline if they had better access
to financing for commercially viable projects and did not have to rely
as much on retained earnings.

In any case, wouldn’t a decline in investment growth hurt China’s
long-term growth prospects? Quite the contrary. Reducing China’s
overall investment growth and directing capital toward more economically
efficient uses is in fact essential to help ensure the durability of China’s
economic expansion. Moving in this manner toward domestic demand-led growth,
and tilting domestic demand itself toward consumption-led rather than
investment-led growth, would help put China on a more sustainable growth
path.

This is where exchange rate flexibility comes in as well. The link is
a subtle one. Since most Chinese saving is intermediated through the banking
system, a more commercially-oriented banking system would ensure a more
efficient allocation of resources in the economy. And this, in turn, would
require that banks respond to market-based measures to control economic
activity. The instruments that are typically employed in such circumstances
in market economies include the short-term interest rate. In the absence
of exchange rate flexibility, however, the independence of monetary policy
had been greatly constrained, even if capital controls insulated the monetary
system to some extent. This resulted in the monetary authority having
to use nonmarket measures such as moral suasion to control credit and
investment growth, an outcome that may have had short-term benefits but
that vitiated the process of banking reforms. The need to sterilize large
waves of capital inflows had also put a heavy burden on the central bank.

While exchange rate flexibility by itself is hardly going to be a panacea,
attaining monetary policy independence through greater flexibility will
eventually remove an important shackle that has hindered financial sector
reforms and restrained other key aspects of the move toward a more market-oriented
economy. This will also provide a useful tool to deal with external shocks
that China will increasingly become exposed to as it continues its integration
with the world economy. Indeed, there is no looking back for China as
its trade and financial linkages bind it ever more closely to economies
both within and outside the Asian region. China’s rising prominence
means that there is much at stake in the outcome of its reform efforts,
not just for China but also for the Asian region and the world economy.

References:

IMF, 2004,"People’s Republic of China: Article
IV Consultation—Staff Report," available on the web
at www.imf.org.